Bank risk‐taking and market discipline: Evidence from CoCo bonds in Korea

• Published date: 01 June 2020
• Date: 01 June 2020
• DOI: http://doi.org/10.1002/fut.22097
• Author: Younghwan Lee,Haerang Park

J Futures Markets. 2020;40:885–894. wileyonlinelibrary.com/journal/fut © 2020 Wiley Periodicals, Inc.

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885

Received: 16 August 2019

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Accepted: 8 January 2020

DOI: 10.1002/fut.22097

RESEARCH ARTICLE

Bank risk‐taking and market discipline: Evidence from

CoCo bonds in Korea

Younghwan Lee

1

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Haerang Park

2

1

Economic Statistics Department,

The Bank of Korea, Seoul, Korea

2

Department of Economics, Seoul

National University, Seoul, Korea

Correspondence

Haerang Park, Department of Economics,

Seoul National University, Seoul, Korea.

Email: widhpl@gmail.com

Funding information

Ministry of Education (MOE, Korea) and

National Research Foundation of Korea

(NRF), Grant/Award Number:

21B20130000013

Abstract

We investigate whether the risk profile of contingent convertible (CoCo) bonds

is well‐priced by testing the sensitivity of bond spreads to bank asset volatility.

While equity holders (bankers) have an incentive to make riskier investments to

trigger the write‐off, such risk‐taking behavior can be contained if CoCo bond

investors punish it by demanding higher returns. We have found that investors

in the Korean financial market understand the risk profile of CoCo bonds and

require higher returns for the additional bank risk, which suggests the presence

of market discipline with regard to CoCo bonds.

KEYWORDS

bank risk‐taking, contingent convertible bonds, market discipline

JEL CLASSIFICATION

G12, G21, G28

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INTRODUCTION

We investigate whether the risk profile of contingent convertible (CoCo) bonds is well‐priced by testing the sensitivity

of bond spreads to bank asset volatility. Compared with other senior and subordinated bonds, CoCo bonds contain an

additional risk of being automatically converted into equity (conversion type) or written down to zero (write‐down type)

in banking crises. Rational investors take this additional risk into account by reacting more actively to a change in

bank's soundness and demanding higher returns as compensation. In this way, bank's risk‐taking can be monitored and

disciplined by the market, which the Basel Committee on Banking Supervision (BCBS) has emphasized as the third

pillar in the Basel II and III international regulatory frameworks (BCBS, 2011). However, “many are skeptical that the

extra yield banks offer really reflects the dangers”of CoCo bonds (Beardsworth & Glover, 2017). To test for the presence

of market discipline regarding CoCo bonds, we use bank credit default swap (CDS)‐implied asset volatilities as a proxy

variable of bank's underlying risk and regress bond spreads on them after controlling for bank‐and bond‐specific

characteristics, and macroeconomic factors. We have found that investors in the Korean financial market understood

the risk profile of CoCo bonds and required higher returns for the additional bank risk in the period from October 2015

to September 2018.

The risk profile of CoCo bonds has recently gathered attention with concerns mounting over the possibility of

coupon suspension or principal write‐down. CoCo bonds are debt instruments designed to improve the resilience of

the financial system and reduce the bailout burdens of taxpayers. In recent years, banks have increased the issuance

of CoCo bonds to accumulate additional capital under Basel III while investors prefer to buy the bank bonds in

searchofyieldamidrecord‐low interest rates. However, the relatively high yields come at the cost of the potential

risk that the bond holders have to bear in cases of the issuing bank's financial distress. Koziol and Lawrenz (2012)

describe the risk as a wealth transfer from CoCo bond holders to equity holders and Berg and Kaserer (2015) argue